Money creation in the modern economy - Quarterly Bulletin - YouTube

Ryland, your article is about how money gets created.

We're surrounded here by gold in the vaults of the Bank of England and historically in

the Gold Standard, the amount of gold would have been related to the stock of money in

the economy.

Things are very different now.

In the modern economy, where does money come from?

Well, let's start off with narrow, or central bank money.

As the name suggests, central bank money is determined by the Bank of England and consists

of notes and reserves.

In normal times, at least, notes and reserves are determined by the amount of notes that

people want to hold or need for their transactions and the amount of notes and reserves the banks

want to hold, given the level of interest rates in the economy.

It is not chosen or fixed by the central bank, as is sometimes described in some economics

textbooks.

Your article focuses on broad money.

What determines how much of that there is?

Well, broad money, which in many ways is a better measure of the amount of money circulating

in the economy, includes all the bank deposits of households and companies.

And one of the key points of the article is that banks create additional broad money whenever

they make a loan.

Now, while this is nothing new, it's sometimes overlooked as the main way in which money

is created and it runs contrary to the view sometimes put forward that banks can only

lend out deposits that they already have.

In fact, loans create deposits, not the other way around.

Now, your article explains in more detail how lending creates money.

It also explains how there are limits to how much banks are likely to create new money

as a result of lending.

These could be profitability considerations of the banks themselves through to how households

and companies react in aggregate to having increased deposits as a result of higher lending.

That's right.

So if banks create money through lending, what, then, is the role of the monetary policy

of the central bank in this story?

Well, you mentioned some of the limits to how much banks will lend in practice.

Monetary policy provides the ultimate limit.

In normal times, say, before the Great Recession, monetary policy is set through interest rates,

and that determines the loan rates that are faced by borrowers in the economy and the

amount of interest that banks pay out to depositors.

And this directly affects the amount of lending that goes on in the economy and the amount

of broad money that's created as a result.

So, obviously, that's normal times.

In the wake of the Great Recession, we've seen Bank Rate reduced to close to zero and

the Monetary Policy Committee embark on a series of asset purchases often referred to

as quantitative easing, or QE, to stimulate the economy further.

Now, your article discusses a number of myths relating to how QE affects the money supply.

Now, QE serves to increase the number of reserves that commercial banks hold at the central

bank, but the first myth you discuss is the idea that this, in some sense, represents

free money for banks.

What's wrong with that account?

Well, it's true, as you say, that QE will lead to an increase in the reserves that banks

hold with the Bank of England.

But if you consider what's going on in the balance sheets of the parties involved, you

can see that it's not really free money.

The main point is that QE mainly involves buying government bonds from pension funds

and other asset managers, not from banks.

The pension fund in this example receives money in their bank accounts, shown here in

red, in exchange for those government bonds, shown in purple.

The banks simply act as an intermediary to facilitate this transaction between the central

bank and the pension fund.

The additional reserves, shown in green, are simply a by product of this transaction.

Now, while banks do earn interest on the newly created reserves, the key point is that QE

also creates an accompanying liability for the bank in the form of the pension fund's

deposit, which the bank will itself pay interest on.

In other words, QE leaves banks with both a new IOU from the Bank of England but also

a matching IOU to consumers -- in this case, the pension fund -- so in that sense it's

not really free money.

Also, starting from the fact that QE increases reserves, the second myth that you discuss

is the idea that these reserves are then multiplied up into additional loans and this is what

gets the economy going.

Indeed, this is the essence of the so-called money multiplier theory of monetary policy

and how that stimulates the economy found in many economics textbooks.

How is this account misleading?

Well, it's true, as we've discussed, that QE will lead to additional reserves held by

the banking system, but banks cannot lend those reserves directly to households and

companies; they have to make additional loans and matching deposits.

And the simple fact of banks having more reserves will not materially affect their incentive

to make lots and lots of additional loans to households and companies in the way the

money multiplier mechanism that you mentioned would suggest.

So, how does QE affect the economy?

QE affects the economy mainly through the extra bank deposits that pension funds and

other asset managers end up holding.

Those asset managers will use those deposits to buy higher yielding assets, such as bonds

and equities that companies issue, that will raise the value of those assets and lower

the cost to companies of borrowing using those instruments.

That's the key way in which spending in the economy is affected.

But that could also mean that QE might reduce bank borrowing if companies use some of the

funds raised by issuing bonds and equities to repay some of their bank loans.